Unintended side effects – mortgage interest deduction

One of the main reasons I have such a strong libertarian bent is because I’ve seen so many unintended side-effects from various government programs. It’s almost impossible to create a policy, tax break, or program that doesn’t affect the behavior of the free market.

The point of this list isn’t to say that these programs are bad or harmful. In fact, I agree with the stated goals of most of the programs that I’ll be examining. Unfortunately, as we’ll see, these programs always have unintended side effects that sometimes completely overshadow the effect of the program.

The first program we’ll look at is the tax deduction for mortgage interest. This is one of the best known and most popular tax deductions.

 

Federal deduction for mortgage interest

 

The stated goals

Encourage home ownership by making home ownership more affordable for lower and middle-class people. By providing a tax deduction for the interest paid on a mortgage, the overall cost of home ownership is decreased.

Explanation of program

The government wants to encourage home ownership for number of reasons:

  1. Homeowners tend to stay in their house longer than renters. This encourages a sense of community and stability. This results in safer neighborhoods, higher property values, etc.
  2. Homeowners have a higher net worth than renters (although I think you can argue that this is correlation, not causation).

These are laudable goals. Unfortunately, making mortgage interest deductible is a pretty ineffective way to achieve these goals.

 

Unintended side effects

It increases housing prices

This side effect surprises people, but let me walk you through it. Let’s say you could spend up to $1,000/month to buy a house. You talk to your loan broker and he says that 30-year loans are currently available at 5% interest rate. This means you can buy a house that costs up to $186,281.62 (we’ll ignore taxes and insurance for now). Your first payment will consist of $776.17 of interest and $223.83 of principle. If you’re in the 25% tax bracket, your tax savings are your marginal tax rate * your mortgage interest, or .25 * 776.17 = $194.04. This means that after the tax deduction you’re actually paying $1,000 – $194.04, or a total of $805.96. After taxes, you’re only paying $805.96/month for the house. Mission accomplished…right?

WRONG.

It’s true that the house AT THIS PRICE is now less expensive for you. But it’s also less expensive for everybody else who wants to buy it with a mortgage. If somebody else, like you, is able to pay $1,000 to live in the house, but with the current mortgage deduction they would only pay $805.96, what do you think is going to happen? They can bid up the price of the house as long as the after-tax cost is less than $1,000/month. Maybe they put in an offer of $190k. Even if you pay $200k for the house your monthly payment would be $1,073.64/month, or $846.90/month after the tax break.

The price of the house will be bid up because the cost of owning it is decreased by the mortgage deduction. This happens through the country, in every housing market, leading to higher prices everywhere.

The tax breaks are disproportionately given to the rich

Rich people pay higher marginal tax rates. If you and I both pay $10,000 in mortgage interest, but you’re in the 35% tax bracket and I’m in the 15% tax bracket then you get a $3,300 reduction in taxes and I get a $1,500 reduction in taxes – even though we’ve paid exactly the same amount of interest!

In addition, the mortgage interest deduction is only useful to the extent that it, plus your other itemized deductions, exceeds the standard deduction. For a married couple the standard deduction is $12,700. If your total itemized deduction (of which the mortgage deduction is the largest component for virtually everybody) is less than $12,700 then you’ll just take the standard deduction, which means you’re effectively getting NO deduction for your mortgage interest. In fact, the best way to think about the value of your mortgage deduction is to take your total interest paid, subtract the standard deduction, then multiply by your marginal interest rate. So, if you pay $15,000 in mortgage interest this year, most people would say that you saved 15,000 * 25% = $3,750 in taxes. In reality the value is (15,000-12,700) * 25% = $575. Larger amounts of mortgage interest (meaning larger mortgages used by richer people to buy more expensive houses) are more likely to exceed the standard deduction threshold.

Theoretically this is the opposite of what our progressive system of taxation is trying to accomplish (shifting taxes to the wealthy).

It encourages debt

Since you receive a tax deduction if you buy a house with a mortgage but no deduction if you buy the house for cash, there’s an incentive to go into debt rather than pay with cash.

In addition, since the deduction is based on actual interest paid, you get a larger deduction for paying more interest. This effectively encourages consumers to purchase more expensive homes than they would otherwise buy.

If anything, the government should be DISCOURAGING debt, not encouraging it.

 

Possible fixes

Turn the tax deduction into a tax credit

This could be implemented a few ways. One would be a simple tax credit to anybody who is a home owner (similar to how the child credit works). This would eliminate the situation where a person in a higher tax bracket receives a larger tax break for the same amount of mortgage interest than a person in a lower tax bracket.

Another way would be a tax credit based on the value of the house, up to some maximum credit amount. This would eliminate the situation where a person who bought a house with a mortgage is treated differently than somebody who bought a house with cash.

However the tax credit is implemented, it should be refundable so everybody can benefit, even people in lower tax brackets who might end up paying no federal taxes.

 

Cap the deduction

The idea here is to allow up to some maximum amount of interest to be deductible (say, $10,000 of interest per year).  The idea is to reduce the benefit to the rich by capping the amount they can benefit from a deduction. I think this is the least interesting fix, as it doesn’t address some of the other issues – it still encourages people to go into debt, and the same amount of interest provides different amounts of deductions for people in different tax brackets.

Phase out the deduction entirely

You can’t just turn off the mortgage tax deduction, as for many people their home is only affordable due to the tax deduction from their mortgage. If it were decided that the tax deduction should be eliminated then it should be eliminated over a long period of time. I’d say at least 10 years, but 30 years might be better. The deduction could be reduced by 1/10th per year (or 1/30th per year if a 30-year timeframe was chosen) to give current homeowners plenty of time to adjust.

 

Conclusion

Let me start by saying that I don’t think the government should be in the business of encouraging people to buy things, especially if the government is encouraging people to buy things by going into debt.

Here’s an interesting data point – most developed counties don’t allow interest on a mortgage to be deducted. The US, Netherlands, and Switzerland are the only counties that allow all of the interest on a mortgage to be deducted, and Belgium, Denmark, Ireland, and Sweden allow a partial deduction.

If a tax deduction for mortgage interest accomplished the goals above you’d think that most countries would have this policy. The fact that most counties DON’T have this deduction is likely because of the unintended side effects of this policy.

Although I personally benefit from this tax break, the reality is that it’s poorly thought out and suffers from serious side effects that wipe out the benefit of the stated goal.

 

What are your thoughts on the federal deduction for mortgage interest? Do you think it accomplishes its goals? Did I miss any of the unintended side effects? Do you have any suggested fixes?

 

3 thoughts on “Unintended side effects – mortgage interest deduction

  1. I haven’t reviewed recent tax law, but I believe another facet to the mortgage interest deduction is that it starts to get limited above a certain income threshold. So the deduction gets phased out for high income earners. It will probably happen to you this year.

    1. Ah yes, the phase-out of itemized deductions. You are right that it will hit us this year, but the reality is that you have to have significant income for the phaseout to affect your mortgage deduction. Here’s how it works:

      First, the phaseout starts when your AGI exceeds $311,300 if married filing jointly or qualifying widow(er), $285,350 if head of household, $259,400 if single, or $155,650 if married filing separately. Your itemized deductions are reduced by 3% of the amount that your income exceeds these thresholds and can reduce your deductions by up to 80%.

      If you’re married and file jointly and have an AGI of $411,300, then your itemized deductions will be reduced by 3% of ($411,300 – 311,300), for a total of a $3,000 reduction. If your AGI is $1M then your itemized deductions are reduced by (1,000,000 – 311,300) * 3% = $20,611.

      However, this is unlikely to end up reducing your mortgage deduction because either: 1) you live in a state with state income taxes, in which case your state income taxes at this income level are higher than 3%, meaning your mortgage deduction isn’t affected, or 2) if your state doesn’t have income taxes it has higher property taxes, in which case your property taxes are likely higher than the phaseout.

      1. Hmmm… the tax code is complicated. It also depends on if you owe AMT. Under AMT calculations, the state tax deduction is not allowed. I think that means your mortgage deduction gets affected.

        I actually support getting rid of the mortgage interest deduction. As you stated, it has a lot of unintended side effects and creates some weird incentives.

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